Zoom Is Zooming Into Massive Growth

Zoom Telephonics (ZMTP, $1.73) is a microcap that is about to experience explosive growth. In 2015 they did $10.8 million in revenue and their 2016 goal is to do between $50 and $100 million. This ramp up is due to a large contract win they announced last April with Motorola. The stock is up around 800% since then! But if management hits its projections, Zoom’s stock could have a lot more gas left in the tank.

Business overview

Not counting the Motorola deal, Zoom mostly sells low-end modems and modem/router combinations (but not routers). They sell modems for cable Internet, DSL, and even 56k. Never would I think that in 2016 I’d be researching two companies that still deal in dial-up Internet. Maybe Sitestar and Zoom need to get together and see who’s legacy dial-up business is shittier.

The market demand for modems isn’t great. Zoom estimates the entire retail market is $150 million and the ISP commercial market (Time Warner, Comcast, etc) is many times that. Zoom currently doesn’t sell to the major commercial players though, their focus is the end user who would rather buy their own modem than rent one from their ISP. Most ISPs charge $7-10/month to rent a modem from them (Time Warner charges me $10) whereas these same modems can be purchased for $50-100. So a personal modem has a payback period of less than one year which is nice, but it’s also a small amount of savings (in terms of absolute dollars) that a lot of people don’t bother with. I didn’t even know you could buy your own modem (also didn’t realize I pay Time Warner to lease mine) until researching Zoom. And even knowing this, I have no desire to go through the effort of dealing with Time Warner to switch to my own modem.

(Side rant: What a great business model ISPs have enjoyed—in most cities, they have a duopoly at worst. Unfortunately, this must encourage shitty customer service because seemingly everyone hates their ISP. They have no reason to spend money making their customers happy when those customers don’t have anybody to switch to. Until recently, Time Warner was calling me on a monthly basis trying to sell me landline telephones. LANDLINE. It didn’t matter that every single time I explained there’s no chance in hell I ever purchase a landline and to please stop calling. I finally blocked every number they call from. Problem solved. I hate dealing with them so much I’d rather pay them $120 a year to rent a modem than go buy my own and have to deal with their “customer service.” Hopefully Google Fiber curb stomps them.)

Anyway. If you think bringing up the rear end of the small modem market isn’t a great business, you are correct. Zoom has been doing $10-15 million a year in revenue for quite a while. Not growing, but not really shrinking either. On this level of sales, they normally lose a little money. It’s been a good enough business to stay in business, that’s about all I can say. A salesman at a retailer I visited recently said something along the lines of “Well you could buy Zoom which is the cheapest, but who knows what you’re getting with that unknown brand.” Luckily Zoom’s business moving forward will look nothing like the fantastic one I just described.

Zoom/Motorola

Motorola isn’t much more than a brand name that gets used by others now-a-days. Lenovo purchased the Motorola phone business recently and now Ashton Kutcher is pimping their phones. Similarly, Motorola’s modem business was purchased by Arris (ARRS) years ago and Arris was selling Motorola branded modems until recently. Motorola has been in the modem business for a long time and they get a lot of respect for having the most high end models. Motorola ditched Arris last year and signed a licensing agreement with Zoom that expires at the end of 2020. One reason Motorola switched is that Arris was co-branding the modems as Motorola/Arris (Zoom’s Motorola models will have no mention of Zoom on them). You can see Arris’ previous packaging on the left and the new packaging on the right.

Very little difference besides the couple small Motorola logos. Zoom management estimates Arris was doing $50-100 million per year in Arris/Motorola co-branded modems and has thus estimated they can do the same. Their projections for 2016 are $50-100 million in revenue and at least an 8% net margin (they have a lot of NOLs if you’re thinking that net margin is high). Using these numbers, it’s pretty easy to do some quick valuations. Let’s start with a simple one that has the following assumptions:

Management reaches the low end of both of their estimates in 2016 ($50M sales, 8% net margin).

Revenue grows at 10% per year and net margin grows at 5% thanks to some scale advantages.

2% share dilution per year.

Motorola leaves after 2020 and Zoom goes back to (we’ll be generous here) breaking even every year.

That spits out a total value of $1.46 per share vs today’s stock price of $1.73. I think those were reasonable assumptions given what management has told us, so clearly Mr. Market thinks one of the following is true:

Zoom will do more than $50 million this year (and grow it thereafter).

Net margins will be more than 8%.

Zoom will resign the Motorola deal to extend past 2020.

I have a hard time believing they’ll get anywhere close to $100 million (for reasons I’ll describe soon), but let’s say they do $60 million this year with 12% margins, keeping everything else the same.

Much better, but still not crazy undervalued vs today’s price. And that’s assuming net margins are 50% higher than what management said.

How much is the Motorola name worth?

Thought experiment: If you wanted to buy a modem to replace the current one you probably rent, what would you do? I’m guessing a lot of you would go to Amazon, search “cable modem”, see Arris (just Arris, not Arris/Motorola) as the #1 best seller with 4.5 stars and almost 9,000 ratings and your search would be over. If the brand of that highly rated modem was Motorola instead of Arris would it make a difference? What if the brand was Jobox? TP-Link? Noodile? Orange Potato? Motorola is certainly more recognizable than the rest (probably because half of those are fake), but I find it hard to believe Zoom is going to steal Arris’ entire retail modem business away just because of the Motorola name.

First, Arris is a $4.4 billion dollar company that has relationships in place with online and traditional retailers. It’s conceivable that retailers will give Arris more shelf space for the Motorola products, but again, I think Zoom predicting they’ll steal all of Arris’ business is incredibly optimistic. I find it interesting that Arris didn’t have to get a new Amazon listing when they dropped the Motorola name. Now Arris gets to carry that built up goodwill over from the Motorola co-branded products into their new Arris line.

Did you notice how similar the two pictures of the before and after packaging from Arris are? They’re basically identical, minus the Motorola logo that appeared twice on the front of the box. Arris was smart to keep everything else the same. Most people won’t even notice the Motorola name off the packaging.

Another important point is that Zoom said Arris is keeping their #1 and #2 customers (Comcast and Time Warner). From reading reviews, a lot of people who switch modems go buy the same one they’re renting from their ISP. This makes sense because that modem has worked for them and they assume using the same model will be the simplest transition. Going forward, if a Time Warner customer wants to buy his own modem, it’s very likely he looks at his rented one (for the first time ever), sees the Arris brand and the model number, searches for it on Amazon, smiles at all the high ratings that confirm his choice, and doesn’t put anymore thought into it. Why would he?

My guess

While I think management may be overestimating how much revenue Motorola brings in, especially right off the bat, I also think net margins could come in higher than expected. They’re predicting operating expenses to roughly triple which seems crazy to me. They have a couple side projects they’ve been talking about that don’t exactly get me excited,. Maybe they’re planning on ramping those up when the new revenue comes in. Finally, assuming Zoom doesn’t do the things that Arris did to piss off Motorola, a renewal in five years should be likely. Given all that, here’s a simple DCF assuming lower revenue, higher margins and a five year renewal in 2020.

Conclusion

I could be way off base on how people purchase these kinds of products. If I’m buying something I don’t know much about (like a modem) I don’t expect to be familiar with the major players in the space, so I’m going to base my decision off online reviews more than brand awareness. Others might look at their current modem which they’re happy with and simply buy that same one. Finally, for people who are familiar with these things, Arris has been in the business for years and has great reviews on all their products so I doubt dropping the Motorola name from their products will make much of a difference.

I’m going to keep watching this one, but as of now I’m not convinced the story that management is telling will come to fruition. I don’t think they’re lying, I just think they’re very optimistic. If you disagree with some of my assumptions, I highly recommend looking into ZMTP more as the potential is there. A good place to start would be the bullish write-up on VIC from December. His 12-month price target is $7.50. The main difference in that analysis is his assumption of much more margin expansion. While his logic makes sense, if I’ve learned anything investing it’s that management teams are consistently far too aggressive/optimistic in their assumptions. I don’t want to bet on management having low-balled margins by 50%. The above DCFs are very sensitive to margins though. Just changing that final 10-year DCF from a 10% net margin to 12% increases the value from $2.76 to $3.31. If you do some due diligence and think they’ve low-balled margin estimates then Zoom is a screaming buy.

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2 thoughts on “Zoom Is Zooming Into Massive Growth”

I appreciate your thoughtful analysis. One major variable that you didn’t address is the proposed purchase of Time Warner Cable and Bright House Networks by Charter Communications. If the deal happens it will make Charter the third-largest cable company in the United States, behind AT&T and Comcast. Charter’s policy is to provide customers with a cable modem “at no additional cost”. But nothing is free and Charter of course is bundling a modem rental fee into its cable bills. Charter customers who purchase their own modem don’t get a break on their bill. In other words they bring their own modem and still pay the “bundled” rental fee. So, not many Charter customers are buying their own modem. Worse, Charter said it would expand its policy to customers acquired from Time Warner and Bright House. As I’m sure you know Zoom is fighting tooth and nail in hope that the FCC will add a condition prohibiting Charter’s practice. Zoom’s petition and briefs are on the FCC website for anyone to see. (Zoom argues Charter’s practice is prohibited by existing law and FCC regulations). There have been, I believe, a couple of positive signs from the FCC. First, in February the FCC commissioners voted to begin the process of drafting rules allowing consumers to purchase their own set-top box. How can the FCC say we think people should be allowed to buy their own set-top box while allowing Charter (arguably) to skirt existing rules for modems? Second, today the FCC released a set of “Broadband Consumer Disclosure Forms”. The idea is that if providers use the forms for their customers, then the forms provide a safe harbor to prove compliance with the FCC’s 2015 Open Internet Order. The forms are here:

The forms don’t prove that Charter will be made to change (or at least made not to expand its policy to Time Warner and Bright House). But a look at the forms does suggest a separately stated charge for leased equipment is mandatory. It’s also telling that the model forms appeared just as the FCC is supposedly nearing a decision on Charter’s proposed merger.

Thanks for bringing that up as it absolutely is an important part of the thesis. I’m on Zoom’s side, not because I have money on the line, but because I think it’s the right thing to do. Hopefully the FCC agrees, although these things are always hard to predict.

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This blog is for informational purposes only. Everything on this blog is the opinion of Travis Wiedower and should not be taken as investment advice. Clients of Wiedower Capital may maintain positions in securities discussed on this blog.